Mispricing in Tech Stock Carve-Outs Author(S): Owen A

Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs Author(s): Owen A. Lamont and Richard H. Thaler Source: The Journal of Political Economy, Vol. 111, No. 2 (Apr., 2003), pp. 227-268 Published by: The University of Chicago Press Stable URL: http://www.jstor.org/stable/3555203 Accessed: 08/01/2010 15:30 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=ucpress. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. The University of Chicago Press is collaborating with JSTOR to digitize, preserve and extend access to The Journal of Political Economy. http://www.jstor.org Can the MarketAdd and Subtract?Mispricing in TechStock Carve-outs Owen A. Lamontand RichardH. Thaler Universityof Chicagoand National Bureau of EconomicResearch Recent equity carve-outs in U.S. technology stocks appear to violate a basic premise of financial theory: identical assets have identical prices. In our 1998-2000 sample, holders of a share of company A are expected to receive x shares of company B, but the price of A is less than x times the price of B. A prominent example involves 3Com and Palm. Arbitrage does not eliminate this blatant mispricing due to short-sale constraints, so that B is overpriced but expensive or impossible to sell short. Evidence from options prices shows that short- ing costs are extremely high, eliminating exploitable arbitrage opportunities. I. Introduction There are two important implications of the efficient market hypothesis. The first is that it is not easy to earn excess returns. The second is that prices are "correct" in the sense that prices reflect fundamental value. This latter implication is, in many ways, more important than the first. Do asset markets offer rational signals to the economy about where to We thankJohn Cochrane,Douglas Diamond, Merle Erickson, Lou Harrison,J.B. Hea- ton, RaviJagannathan,Arvind Krishnamurthy, Mark Mitchell, Todd Pulvino, TuomoVuol- teenaho, an anonymousreferee, and seminarparticipants at the AmericanFinance As- sociation, HarvardBusiness School, the National Bureau of Economic ResearchAsset Pricingmeeting, and the Universityof Chicagofinance lunch for helpful comments.We thankJoe Cornelland MarkMinichiello of Spin-offAdvisors for data and helpful discus- sions. We thank FrankFang Yu for excellent researchassistance. Lamont gratefully ac- knowledges support from the Alfred P. Sloan Foundation, the Center for Research in Security Prices at the University of Chicago Graduate School of Business, the National Science Foundation, the Investment Analyst Society of Chicago, and the Association for Investment Management and Research. [ournal of PoliticalEconomy, 2003, vol. 111, no. 2] 8 2003 by The University of Chicago. All rights reserved. 0022-3808/2003/11102-0005$10.00 227 228 JOURNAL OF POLITICAL ECONOMY invest real resources? If some firms have stock prices that are far from intrinsic value, then those firms will attract too much or too little capital. While important, this aspect of the efficient market hypothesis is difficult to test because intrinsic values are unobservable. That is why tests of relative valuation, for example, using closed-end funds, are important. The fact that closed-end funds often trade at substantial discounts or premia makes one wonder whether other assets may also be mispriced. The most basic test of relative valuation is the law of one price: the same asset cannot trade simultaneously at different prices. The law of one price is usually thought to hold nearly exactly in financial markets, where transactions costs are small and competition is fierce. Indeed, the law of one price is in many ways the central precept in financial economics. Our goal in this paper is to investigate violations of the law of one price, cases in which prices are almost certainly wrong in the sense that they are far from the frictionless price. Although the number of cases we examine is small, the violations of the law of one price are large. The driver of the law of one price in financial markets is arbitrage, defined as the simultaneous buying and selling of the same security for two different prices. The profits from such arbitrage trades give arbitrageurs the incentive to eliminate any violations of the law of one price. Arbitrage is the basis of much of modern financial theory, including the Modigliani-Miller capital structure propositions, the Black-Scholes option pricing formula, and the arbitrage pricing theory. Do arbitrage trades actually enforce the law of one price? This em- pirical question is easier to answer than the more general question of whether prices reflect fundamental value. Tests of this more general implication of market efficiency force the investigator to take a stance on defining fundamental value. Fama (1991, p. 1575) describes this difficulty as the "joint-hypothesis"problem: "market efficiency per se is not testable. It must be tested jointly with some model of equilibrium, an asset-pricing model." In contrast, one does not need an asset-pricing model to know that identical assets should have identical prices. The same difficulty that economists face in trying to test whether asset prices generally reflect intrinsic value is also faced by real-world arbitrageurs looking for mispriced securities. For example, suppose that security A appears to be overpriced relative to security B. Perhaps A is a glamorous growth stock, say a technology stock, and B is a boring value stock, say an oil stock. An arbitrageur could short A and buy B. Unfortunately, this strategy is exposed to "bad-model" risk, another name for the joint-hypothesis problem. Perhaps the arbitrageur has neglected differences in liquidity, risk, or taxes, differences that are properly reflected in the existing prices. In this case, the trade is unlikely to earn excess returns. Researchers have not been able to settle, for TECH STOCK CARVE-OUTS 229 example, whether value stocks are too cheap relative to growth stocks (as argued by De Bondt and Thaler [1985] and Lakonishok, Shleifer, and Vishny [1994]) or just more risky (as favored by Fama and French [1993]). Another, second, risk for the arbitrageur is fundamental risk. An arbitrageur who shorts technology companies and buys oil companies runs the risk that peace breaks out in the Middle East, causing the price of oil to plummet. In this case, perhaps the original judgment that oil stocks were cheap was correct but the bet loses money ex post. In contrast, if A and B have identical cash flows but different prices, the arbitrageur eliminates fundamental risk. If securities A and B have other similar features, for example, similar liquidity, then bad-model risk is minimized as well. Violations of the law of one price are easier for economists to see and safer for arbitrageurs to correct. For example, suppose that A is a portfolio of stocks and B is a closed-end fund that owns A. If B has a lower price than A, then (when issues such as fund expenses are ignored) the arbitrageur can buy B, short A, and hope to make a profit if the prices converge. Unfortunately, this strategy is exposed to a third sort of risk, noise trader risk. An arbitrageur that buys the fund and shorts the underlying shares runs the risk that the discount may widen as investor sentiment shifts. This risk can be either systematic (all closed-end fund discounts widen) or idiosyncratic (Lee, Shleifer, and Thaler 1991). Since there is no guarantee that A and B will converge in price, the strategy is risky. Noise trader risk can be eliminated in the long run in situations in which A and B are certain to converge in finite time. For example, suppose that at time T the closed-end fund B will liquidate, and all holders of B will receive a cash settlement equal to the net asset value of the portfolio, that is, A. We know that the prices of A and B will be identical at time T Noise trader risk still exists in the intermediate period between now and T, but not over the long run. The terminal date eliminates other concerns as well; for example, liquidity is not an issue for investors holding until time T In this case, with no fundamental risk, bad-model risk, or noise trader risk, there still is another problem that can cause the prices of A and B to be different: transactions costs (including trading costs and holding costs). Both market efficiency and the law of one price are affected by transactions costs. If transactions costs are not zero, then arbitrageurs are prevented from forcing price all the way to fundamental value, and the same security can have different prices. In this case, then, Fama (1991, p. 1575) describes an efficient market as one in which "deviations from the extreme version of the efficiency hypothesis are within information and trading costs." An example is a market in which it is impossible to short a stock, equivalent to infinite transactions costs for short sales.

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